Since the birth of the hedge fund performance fee over 60 years ago (see our “Performance fees as old as portfolio management itself”), this form of compensation has drawn fire from some investors and professional jealousy from asset managers who did not use it. At the heart of the problem is the “free option” that upside participation with no downside represents. Making matters worse, this option – like all others – is worth more when volatility is high. And since the managers themselves influence the volatility of their funds, this represents a serious moral hazard. Needless to say, creating an effective performance fee contract can be a complicated and mathematically ugly process.
In an article for the Spring edition of the Rotman International Journal of Pension Management, Jan Bertus Molenkamp of Vrije University Amsterdam proposes a few modifications to the traditional performance fee arrangement. Getting right to the heart of the matter, Molenkamp says something that won’t come as a shock to some hedge fund investors: “Option-like contracts may even induce uninformed managers to enter into the business.”
But “option-like contracts” also provide a measure of alignment between the interests of manager and investor. It’s just that a performance fee also introduces new mis-alignments. That’s why hurdle rates and highwater marks exist (the latter called “Negative Carry Forward (NCF)” by Molenkamp.) In order to compare apples to apples, he uses the concept of “Equivalent Base Fee (EBF)” developed by Mark Kritzman (see our “Fees six of one or half dozen of the other). As you can probably guess, the EBF is the guaranteed fee rate (% of AUM) that matches a given performance fee when a fund has a certain volatility, hurdle rate etc. In other words, it’s the management fee level that should make the manager indifferent between receiving a performance fee or a management fee.
This is a critical question because, as Molenkamp suggests, management fees incentivize managers to do more marketing (and increase AUM) while performance fee incentivize performance.
Equivalent Base Fee
As Molenkamp shows, the period during which the fund must exceed its highwater mark can influence the value of the option for managers. In the chart below from the article, you can see the EBF for a 20% performance fee at various levels of investment success (i.e. information ratio). When the manager is paid a percent of that return, but has to pay it back if performance is negative, the payoff is said to be linear. When there is no downside, the payoff is said to be an “option”. The chart also shows the payoff when the highwater mark is 3 years old, returns over an infinitely small time (theoretical as the shortest time period we’ve seen for performance fees is a quarter), and the payoff for something between the two: a 3 year old highwater mark with 1/3 of the performance fee paid out in each year.
Molenkamp points out that investors can use this kind of chart when negotiating fees with their managers:
Suppose that a manager has an observed tracking error of four percent and expects to generate an information ratio of 0.5. The manager offers the investor a choice between twenty basis points base fee plus twenty percent outperformance fee (i.e., an option-like structure) or a total fixed fee of forty basis points. This implies the manager is indifferent between a twenty percent performance fee and a base fee of twenty basis points. Under a risk neutral assumption, this implies the manager has an information ratio of -0.35 as shown in Figure 1. If we see this fee proposal a skill signaling tool for a manager who is indeed risk neutral, then the investor should walk away from this offer.
Still, as Molenkamp writes in the Appendix, the manager may just have a thing about volatility (i.e. have a different utility function) and want to simply avoid volatility at all costs.
Another way to address the deficiencies in performance fee arrangements is to ensure the manager has skin in the game. By co-investing alongside their investors, the benefit of a positive management fee can be mitigated by losses to the managers own capital. That way, if the manager wants to play fast and loose with the fund’s assets, he’s strapped into the same roller-coaster with his clients. Assuming the client and the manager get equally sick from riding the roller coaster (i.e. that they have the same utility function when it comes to volatility), then they will both end up turning green at the same time.
The chart below from the article shows that, in the absence of co-investment, the manager’s utility (dark blue line) keeps going up as volatility increases (who cares, it’s not his money). Naturally, the investor’s (black line) utility falls as volatility rises. The mis-alignment of interests occurs when the manager’s utility rises – and the investor’s falls – as the manager ramps up volatility. In other words, the slopes of each line have to have the same sign. But if the manager co-invests, then his net worth takes huge swoons and his utility drops after a point (grey line).
So some extent, this elegant analysis served to confirm a piece of common sense employed by hedge fund and venture capital investors for years. As Molenkamp concludes: “Eat your own cooking should be the motto in the construction of investment fees.”